Indirect Lending Legal Issues

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Tom Wolfe, Managing Partner of Moore Brewer Wolfe Jones Tyler & North

Indirect lending—the process by which financial institutions, including credit unions, purchase retail installment sale contracts from car dealers—is now a well-established lending system.  It is a win-win-win process for all parties involved.  Car buyers are able to purchase a vehicle and obtain financing with little effort through the dealer; dealers are able to sell a vehicle and get payment in full from the credit union that purchases the contract; and the credit union has a steady flow of borrowers and new loans, with the dealer doing most of the due diligence for the credit union on the buyer. 

So, what legal issues arise in the indirect lending setting? 

The Buyer Defaults—if the buyer defaults, the credit union has no remedy against the dealer, unless it can show that there was a material misrepresentation in the loan application, such as overstating the buyer’s income.  Therefore, anytime a buyer defaults, the credit union should always re-review the loan application and related documents submitted by the dealer for material misrepresentations.  If false information was provided, the credit union could have the right to demand that the dealer buyback the contract.  If none can be found, the credit union’s remedy is to repossess and sell the vehicle, and then pursue the member for any deficiency.  

In addition, a buyer under an indirect contract has additional rights following default.  All contracts (for direct and indirect loans) in California are governed by the California Commercial Code.   Indirect loans are also governed by the Automobile Sales Finance Act (ASFA).   If a buyer defaults on a direct loan and the vehicle is repossessed, the buyer’s remedy to get the vehicle back is called “redemption.”  To “redeem” the vehicle, the buyer must pay off the loan in full.  Otherwise, the lender can sell the vehicle and pursue the buyer for any deficiency.  However, in an indirect loan scenario, the ASFA allows the buyer to “reinstate” the contract after default.  Reinstatement allows the buyer to cure the default by paying any past due amounts and any expenses the credit union incurred.  The right of reinstatement can be exercised twice during the term of the loan, but only once a year.  

The Buyer Sues the Dealer and the Credit Union as the “Holder” of the Contract  
The ASFA allows a buyer to sue the credit union as the “holder” of the contract based on the dealer’s alleged bad conduct.  The credit union’s maximum liability is the contract amount, but it is also liable for the buyer’s attorney fees, which often equal or exceed the contract price.  In this scenario, most dealer-credit union agreements require the dealer to defend and indemnify if the credit union is sued, meaning the dealer must provide and pay for an attorney to represent the credit union and must reimburse the credit union for any judgment against it.  If the credit union is named in a holder suit, it should immediately make a written demand on the dealer to defend and indemnify, and should immediately put its own insurer on notice in the event the dealer fails to defend the lawsuit.   Most dealer-credit union agreements also require the dealer to repurchase the indirect contract if the buyer wins the lawsuit. 

The Dealer Goes Out of Business
This is where it gets really challenging.  Part of the savings a credit union obtains in indirect lending is the dealer does all of the DMV paperwork—including getting the credit union on title as the legal owner.   The dealer also is responsible for using the loan proceeds to pay off any existing liens on the vehicle.  (While it will not prevent a dealer from abruptly closing down, a credit union should closely monitor a dealer’s DMV processing to ensure it gets on title timely and that existing liens on the vehicle are paid and released.  Any delay should be a red flag.)

When a dealer goes out of business there are usually a large number of vehicles and financial institutions effected, meaning the credit union can have multiple vehicles for which it is not on title and the buyer may not be able to register the vehicle due to the former lien holder that will not release its lien without payment.  These are complex cases in which several lien holders – including the dealer’s inventory lender and previous sellers in the chain of title – claim an unpaid lien on the vehicle.   Very often, the credit union will have to pay off existing liens (in effect financing the vehicle twice) to clear title and will have no remedy against the out-of-business dealer.  If you are faced with this scenario, time is critical so you should immediately contact your attorneys. 

While indirect lending is a valuable lending platform, it does require credit unions to diligently monitor both their member’s and dealer vendors to mitigate losses and maximize returns. 

Article by Tom Wolfe, Managing Partner of Moore Brewer Wolfe Jones Tyler & North.

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